S.E.C. Real Estate Observer

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Many exchangors think they know all they need to know about exchanging if they know how to put together a section 1031, tax deferred exchange, take a house trade-in, or have a client “willing to take something in trade that can be sold out of escrow – for cash.” This is fine as far as it goes, but if your thinking, and training, only go this far – then you’re passing up the most important reason for exchanging – marketing problem properties.

First, let us examine when you should “think exchanging.” Contrary to what some exchangors will say, some situations (properties) lend themselves to sales. Barring tax problems, single family residences in a Seller’s market and absolutely net leased commercial and industrial properties probably are sales type properties. But the broker should “think exchanging” anytime he has a difficult property to move, or a client who will have an income tax problem if he sells. Pages and books have been written about tax problems, and tax deferred exchanges, and excellent courses are offered covering this ground. This article is to explore ideas on the main reason for exchanging – marketing a difficult property.

A broker should not even attempt to solve a difficult real estate problem without the client recognizing and admitting they have a problem. The broker and client must agree on what is possible, and the broker should not work on impossible, or even highly improbable solutions. At least not on a contingency basis. The client who reluctantly agrees that he would take a long-term, absolutely net leased, Safeway Store for his encumbered desert land is not dealing in the art of the possible. To be successful, any real estate transaction must have benefits for both sides. I am very skeptical of anyone who brings me an offer where only my client will benefit. Something must be wrong with their property that they are not telling me about. More often than not, other brokers bring me offers where only their client will benefit. Both parties must improve their position in some way or they have no reason to make the transaction.

Over the years, I have seen many properties exposed on the exchange market, and I have found that properties are desired in a direct relationship to their ability to be converted to cash, their ability to produce income, and their ability to produce tax benefits, in that order. Excluding properties for which there is a user, and with cash as the yardstick, the following is the Allen order of desirability of property:

1. Twenty-five year leased. single tenant building, leased to Bell Telephone, 14% NNN return, cost of living increases, w/6% assumable loan.

2. Cash

3. F&C House

4. F&C Income Property

5. Cash Flow Income Property

6. Paper

7. F&C Developable Land

8. F&C Personal Property

9. Break-Even Income Property

10. F&C Cold Storage Land

11. Negative Cash Flow Income Property

12. Negative Cash Flow Development Land

13. Negative Cash Flow Cold Storage Land

To briefly explain why the order is as it is: Number one could quickly be sold for more cash than 100%; Houses can probably be immediately financed (cranked) for 80 to 90% and traditionally sell quickly. Income property can usually be financed for 50-80% of value and produce obvious cash flow and tax benefits. The paper can be hypothecated, or sold, but usually at a substantial reduction depending on quality. A buyer can usually be found eventually for developable land. Personal property can be fun. The free and clear cold storage land does nothing for the new owner one way or the other, except beef-up his financial statement, while the negative cash flow income property hurts. Negative cash flow land hurts most of all as it doesn’t even offer tax shelter.

So, in theory, it should be easy to convince a client to make the move up the property ladder; for instance, from Number 13 to Number 9, or from Number 7 to Number 5. The creativity in real estate exchanging is making it beneficial for the higher number to move down. Here are a few ways to make the trade down possible.

1. Find a User – For instance, a developer with cash flow income property (Number 5) might very well take negative cash flow land (Number 12) if he could develop it.

2. Over Trade – A person with cash flow income property (Number 5) or even free and clear income property (Number 4) might take paper (Number 6) if enough is offered.

3. Change Use – Having a solution to negative cash flow problem (Number 11) can change to a Number 9 or Number 5, making it desirable for the numbers in between.

4. Change What You Are Exchanging – A take-out leg can change a break-even income property to paper, cash and paper, F&C land and paper, or a smaller income property and paper. A user can change negative cash flow development land into a cash flow income property.

5. Make Your Property More Attractive – Take off the loans or offset them. You can change negative cash flow land and income properties to break even or even cash flow.

6. Sweeten – Negative cash flow, cold storage land is hard to swallow by itself. By adding sufficient cash, paper, or other goodies, it takes on a completely different taste. Other, less desirable properties can advance in acceptability when sweetened.

7. Solve the Other Party’s Problem – The willingness to take on and solve problems on another’s potentially more desirable property often can be the factor that will make the exchange work. Examples: Finding a user for a vacant motel or restaurant; using management expertise to solve vacancy problems; financial muscle to refinance an over encumbered property or one with short-term loans; willingness to take on a property in litigation; willingness to work out title problems; willingness to develop out all, or part, of a property; willingness to make payments when locating a tenant (feeding and eat).

Where there are problems, there are solutions. The real estate exchangor, to be effective, must be creative, but he must also be practical. If the client doesn’t recognize that he has a problem, the broker cannot help him. The pie-in-the-sky dreams, the needle-in-the-haystack search for the McDonald’s Hamburger building owner who might want a little twenty acre parcel near Winnemucca, Nevada, will waste time and create bitterness. Tell the client the facts of life – the solutions he can expect – the problems he will need to solve. If he doesn’t want to list with you under those conditions, let him go to another broker. Practical exchangors make money and perform a very valuable service. The others waste everyone’s time, especially their own.

Editor’s Note: This article was originally published thirty years ago in the R.E. Observer in 1975.